The Importance of Surety Bonds in ConstructionConstruction is a risky business. One-half of all construction firms in business today will be out of business six years from now, according to the Associated General Contractors of America. An economic downturn, labor difficulties, material shortages, equipment problems, and a host of many other problems can cause a contractor's business to fail leaving projects at a standstill.
No construction project owner, public or private, can afford to gamble on a contractor whose responsibility is uncertain or who could end up bankrupt halfway through the job. And how can a public agency, which uses the low-bid system in awarding public works contracts, be sure the lowest bidder will be dependable?
A surety bond provides financial security and construction assurance on building and construction projects by assuring project owners that contractors will perform the work and pay their subcontractors, laborers, and material suppliers.
In other words, a surety bond is a risk transfer mechanism where one party guarantees to another that a third party will perform a contract.
The three parties involved are:
1. The surety
2. The owner
3. The contractor.
This three-party system involves three types of surety bonds: the bid, performance, and payment bond.
Types of Bonds
The bid bond provides financial assurance that the bid has been submitted in good faith and that the contractor intends to enter into the contract at the price bid and provide the required performance and payment bonds.
The performance bond protects the owner from financial loss should the contractor fail to perform the contract in accordance with its terms and conditions.
The payment bond guarantees that the contractor will pay certain subcontractors, laborers, and material suppliers associated with the project.
Surety bonds have been around since 2750 BC, when the historian Herodotus told of contracts of suretyship. The year 670 BC marked the execution of the oldest surviving written surety contract, a contract of financial guarantee.
While suretyship is an ancient practice, it wasn't until the latter part of the 19th century that the writing of surety bonds by corporations came into being. Since 1893, the U.S. Government has required contractors undertaking federal public work contracts to post surety bonds guaranteeing that they will perform such contracts and pay certain labor and material bills.
The federal law mandating surety bonds on federal public work is known as the Miller Act of 1935 (40 U.S.C. Section 270a-f). It requires performance and payment bonds for all public work contracts in excess of $100,000. Also, each of the 50 States, the District of Columbia, Puerto Rico, and almost all local jurisdictions have enacted legislation requiring surety bonds on public works. These generally are referred to as "Little Miller Acts."
Financial Security & Construction Assurance
While surety bonds are mandated by law on public works projects, the use of surety bonds on privately-owned construction projects is at the owner's discretion. Alternative forms of financial security, such as letters of credit and self-insurance, don't cover the risks inherent in construction as well as surety bonds. For that reason, an increasing number of private owners are requiring surety bonds from their contractors. With a surety bond, the owner can be satisfied that a risk transfer mechanism is in place. The risks of construction are shifted away from the owner to the surety. If the contractor defaults, the surety may pay for a replacement contractor, finance the existing contractor, or provide technical assistance.
Although surety bonding is considered a line of insurance, it has many characteristics of bank credit. The surety does not lend the contractor money, but it does allow the surety's financial resources to be used to back the commitment of the contractor, thus enabling the contractor to acquire a contract with a private owner. The owner receives guarantees from a financially responsible surety company licensed to transact suretyship.
Prequalification of the Contractor
How does a surety begin to shoulder this burden of risk? Primarily through a rigorous and professional process in which surety companies prequalify contractors. This prequalification process is an in-depth look at the business operations of the contractor. Before issuing a bond the surety needs to be fully satisfied, among other criteria, that the contractor:
is of good character;
- has experience matching the requirements of the project;
- has or can obtain the equipment necessary to do the work;
- has the financial strength to support the desired work program;
- has an excellent credit history;
- has established a bank relationship and a line of credit.
Sureties have played an important role in the construction industry's success, allowing the industry to sustain its position as one of the largest contributors to the nation's economic stability and growth.
The biggest peril of a construction project is the possibility of contractor failure. Dun & Bradstreet's Business Failure Record reports that from 1990 to 1997, more than 80,000 construction firms failed. Liabilities of the failed firms exceeded $21 billion.
Surety bonds, a dependable, proven, and reliable protection against contractor failure, cost between one and three percent of the total contract price. On very large projects, surety bonds may cost less than one percent. Surety bonds are a wise investment in protecting an owner from contractor default.
Functions of Bonds
Contract surety bonds perform the following functions:
- guarantee that the bonded project will be completed according to the terms of the contract and at the determined contract price;
- guarantee that the laborers, suppliers, and subcontractors will be paid even if the contractor defaults and can result in lower prices and expedited deliveries;
- smooth the transition from construction to permanent financing by eliminating liens;
- reduce the possibility of a contractor diverting funds from the project;
- provide an intermediary - the surety - to whom the owner can air complaints and grievances;
- lower the cost of construction in some cases by facilitating the use of competitive bids.